These High-Yield Stocks Face Tough Competition, But Investors May Win

Business development companies make money by lending to private-equity buyouts and private businesses.

The industry is small -- add up the total assets of all the players and you'll barely have enough to form a single "systemically important financial institution," a designation for companies with more than $50 billion in assets. Around the world, more than 30 banks hit that threshold on an individual basis. Suffice it to say that BDCs and other non-bank lenders are still a drop in the global financial bucket.

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But the industry is growing, in part due to investors' insatiable appetite for dividends. BDCs are required by law to pay out virtually all of their income to avoid corporate income tax. Thus, dividend yields often top 10% per year, making them attractive to investors who want to add a little extra income to their portfolios.

Growing in dark cornersWhile the number and size of publicly traded BDCs are growing -- many now manage billions of dollars compared to millions before the financial crisis -- private BDCs are growing even faster.

Private BDCs are in many ways the industry's "farm team." They grow quietly, raising money by selling stock through financial advisors. Many then choose to go public for access to added liquidity -- one drawback of unlisted BDCs is that there is no market for their shares.

Some unlisted business development companies have swelled to a size that would put them in the top five BDCs by assets if they were publicly traded. The table below shows assets in private BDCs as of their last quarterly or annual report with the SEC.

Source: Annual and quarterly reports filed with the SEC.

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The boom is also leading to a bust, at least in one respect: Increased competition means loan yields have fallen since the financial crisis.

But competition for deals is just one piece of the puzzle. Business development companies are also competing for investor capital.

Earlier this year, FS Investment Corp. went public, catapulting to become the fourth-largest publicly traded BDC. Prior to its IPO, the company changed its management fee arrangement so that incentive fees for good performance are paid only when the company produces a satisfactory return on equity (7.5%) over the preceding three years.

More importantly, it adjusted for the fact that returns on equity will be higher when the value of its portfolio falls. If its book value drops faster than income, it will inevitably result in a higher return on equity. Investors shouldn't compensate management teams for destroying book value at a faster rate than income, but that's how many agreements pan out -- investors in many BDCs pay more for worse performance.

All in all, the management fee maneuver ultimately means investors will pay less in fees as a percentage of assets over the long haul. Many of the legacy BDCs have no such arrangement -- they'll actually earn bigger fees if their portfolios go down in value.

While fees aren't everything, expenses play a key part in a company's ability to generate returns for investors. While the least-efficient BDCs will spend 35%-40% of revenue on operating costs, including management compensation, the most efficient spend as little as 20%. The savings ultimately flow through to bigger dividends and higher stock prices.

The catalystMain Street Capital , a publicly traded BDC and manager of the $500 million HMS Income Fund, said during its latest conference call it expects the party in private fundraising to wrap up. Regulatory pressure and a shifting tide of sentiment away from private BDCs will bring an end to the days when companies can raise billions of dollars through financial advisory channels.

The end game is that many of the private BDCs today will seek a public listing on a faster timeline than originally expected. When private sources of funds dry out, their managers will inevitably turn to the public markets.

To do so, they'll need to offer something special to attract investor interest. Lower fees are an easy "something special" -- it's not a coincidence that the most-efficient BDCs generally enjoy higher stock prices than the least efficient.

So, while competition might hurt on the top line in loan yields, it could be a boon at the bottom line, as BDCs are forced to be more shareholder-friendly to stand out in an increasingly crowded industry. Don't cross your fingers, but the same competitive dynamics that have recently driven down dividend yields at many BDCs may ultimately force the industry to adopt lower fees, resulting in better returns for shareholders.